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Monday, April 3, 2017

A Challenge to the Fed's Normalization Plans: the IOER-Treasury Yield Spread

Over at U.S. News and World Report, I have a new article up on the next big challenge facing the Fed: normalizing its balance sheet. Some excerpts:

This path to monetary policy normalization.... may be fraught with surprises and setbacks. Not only must the Fed avoid getting ahead of the recovery with its interest rate hikes, but it must delicately navigate the shrinking of a balance sheet that has grown fourfold since 2008.
This latter task may prove to be especially daunting since it puts the Fed in unchartered waters. Never before has the Fed had to shrink its balance sheet...

I go on to discuss some of the many challenges the Fed may face in attempting to shrink its balance sheet. One of them is dealing with the potential stresses caused by the new regulatory demands of the liquidity coverage ratio running up against the spread between IOER and treasury bills:

The second reason the scaling back of the Fed's balance sheet may be challenging is that post-2008 regulation now requires banks to hold more liquid assets. Specifically, banks now have to hold enough high-quality liquid assets to withstand 30 days of cash outflow. This liquidity coverage ratio has increased demand for such assets of which bank reserves and treasury securities are considered the safest. So, in theory, as the Fed shrank its balance sheet, the banks could simply swap their excess reserves (that the Fed was pulling out of circulation) for treasury bills (that the Fed was putting into circulation). The challenge, as observed by George Selgin, is that the Fed's interest on excess reserves has been higher than the interest rate on treasury bills. This creates relatively higher demand for bank reserves.

Banks would not want to give up the higher-earning bank reserves at the very moment the Fed was trying to pull them out of circulation. This tension could create an effective shortage of bank reserves and be disruptive to financial markets. The solution here would be for the Fed to lower the interest on excess reserves to the level of treasury bill interest rates.

The figure below illustrates this potential problem. It shows the Fed's upper and lower bounds on the federal funds, the effective federal funds rate, and the 4-week treasury bill interest rate. These upper and lower bounds have created a successful corridor system for the federal funds rate, but they have not been very good at bounding the 4-week treasury bill yield. Moreover, the spread between the IOER--the upper bound--and the 4-week treasury bill has persistently been sizable and gotten larger on average since the first interest rate hike in December 2015. It is hard to see why banks would want to swap their excess reserves for treasury bills given this spread.

This is just one of the challenges the Fed faces in shrinking its balance sheet. Read the rest of the piece for the others I outline.

P.S. While it is easy to understand why the effective federal fund rates falls within the corridor, it is not clear why the 4-week treasury bill interest rate has not conformed to it. Arbitrage should push them closer together, so there must be some friction. One obvious one is the limited access to the Fed's balance sheet. Even with RRP, there are still only so many firms that can effectively tap into the Fed's balance sheet. I suspect that if the Fed further opened up its balance sheet some of this spread would disappear. Whether that is a desirable objective, however, is an altogether different question (though it is discussed in this weeks Macro Musings podcast).

I've been confused about the Fed's chosen path since Dec 2015 (the first increase in IOR). Why not start letting the balance sheet gradually shrink instead? Reverse QE so to speak. They'd still be buying all the time as the amount of T-bill maturities and MBS amortization would exceed the likely desired balance sheet runoff. Frankly, I find it crazy (and it should be criminal) for the Fed to pay a higher rate for overnight money than the Treasury has to pay. IOR is now close the the rate on 1-year Treasuries. It's crony capitalism as only a select group can get this rate paid to them. And what will they do when the bill for paying IOR exceeds the interest they are earning on their portfolio?